Split-Dollar Regs Contrary to Basic Tax Policy, Say Insurance Reps


Insurance representatives at an October 23 IRS hearing in Washington urged Treasury and IRS officials to rethink the policy behind proposed regs governing income, employment, and gift taxation of split-dollar life insurance arrangements.

Document Type: News Stories

Tax Analysts Document Number: Doc 2002-23978 (3 original pages) [PDF]

Tax Analysts Electronic Citation: 2002 TNT 206-1

Citations: (23 Oct 2002)


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Insurance representatives at an October 23 IRS hearing in Washington urged Treasury and IRS officials to rethink the policy behind the proposed regs (REG-164754-01) governing income, employment, and gift taxation of split-dollar life insurance arrangements.

The proposed regs generally define a split-dollar life insurance arrangement as any arrangement -- not part of a section 79 group term life insurance plan -- between an owner of a life insurance contract and a nonowner of the contract in which either party pays all or part of the premiums, and one of the parties paying the premiums is entitled to recover, conditionally or unconditionally, all or any portion of those premiums from the proceeds of the contract. The definition is intended to be applied broadly, and the amount to be recovered by the party paying the premiums need not be determined by reference to the amount of those premiums, according to the regs.

If an arrangement is entered into in connection with the performance of services, the regulations apply a special rule. Under the special rule a split dollar life insurance arrangement is any arrangement between an owner and a nonowner of a life insurance contract under which (1) the employer or service recipient pays any portion of the premiums, and (2) the beneficiary of all or any portion of the death benefit is designated by the employee or service provider or is any person whom the employee or service provider would reasonably be expected to name as beneficiary.

Although the special rule doesn't apply to arrangements covered by section 79, it does apply to arrangements between a corporation and another person in that person's capacity as a shareholder in the corporation under which the corporation pays, directly or indirectly, all or any portion of the premiums and the beneficiary of all or a portion of the death benefit is a person designated by, or would be reasonably expected to be designated by, the shareholder. The rule also doesn't apply to scenarios in which the only parties to the arrangement are the policy owner and the life insurance company acting only in its capacity as issuer of the contract.

Pointing out, for example, the regs' taxation of death benefits and imposition of tax on the inside buildup of life insurance contracts, Laurie Lewis, speaking for the American Council of Life Insurers, said the regs conflict with fundamental tax principles applicable to life insurance products and principles of constructive receipt.

"Section 101 of the code is clear: gross income does not include amounts received under a life insurance contract, if such amounts are paid by reason of the death of the insured," Lewis said. However, the regulations indicate -- contrary to clear statutory authority -- that only a portion of that amount is excludable under section 101, she observed.


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Insurance representatives at an October 23 IRS hearing in Washington urged Treasury and IRS officials to rethink the policy behind the proposed regs (REG-164754-01) governing income, employment, and gift taxation of split-dollar life insurance arrangements.

Background

The proposed regs generally define a split-dollar life insurance arrangement as any arrangement -- not part of a section 79 group term life insurance plan -- between an owner of a life insurance contract and a nonowner of the contract in which either party pays all or part of the premiums, and one of the parties paying the premiums is entitled to recover, conditionally or unconditionally, all or any portion of those premiums from the proceeds of the contract. The definition is intended to be applied broadly, and the amount to be recovered by the party paying the premiums need not be determined by reference to the amount of those premiums, according to the regs.

If an arrangement is entered into in connection with the performance of services, the regulations apply a special rule. Under the special rule a split dollar life insurance arrangement is any arrangement between an owner and a nonowner of a life insurance contract under which (1) the employer or service recipient pays any portion of the premiums, and (2) the beneficiary of all or any portion of the death benefit is designated by the employee or service provider or is any person whom the employee or service provider would reasonably be expected to name as beneficiary.

Although the special rule doesn't apply to arrangements covered by section 79, it does apply to arrangements between a corporation and another person in that person's capacity as a shareholder in the corporation under which the corporation pays, directly or indirectly, all or any portion of the premiums and the beneficiary of all or a portion of the death benefit is a person designated by, or would be reasonably expected to be designated by, the shareholder. The rule also doesn't apply to scenarios in which the only parties to the arrangement are the policy owner and the life insurance company acting only in its capacity as issuer of the contract.

Under the proposed regs, split-dollar life insurance arrangements are taxed under two mutually exclusive regimes: the economic benefit regime and the loan regime. Under the economic benefit regime the owner of the life insurance contract is treated as providing economic benefits to a nonowner. The economic benefit regime will govern the taxation of endorsement arrangements. Under the loan regime the nonowner is treated as lending premium payments to the owner. Except for specified arrangements, the loan regime applies to any split-dollar loan and governs the taxation of collateral assignment arrangements. In contrast to Rev. Rul. 64-328 and Rev. Rul. 66-110, the proposed regs provide substantially different tax consequences to the parties depending on which party owns the life insurance contract, according to the preamble.

Comments

Pointing out, for example, the regs' taxation of death benefits and imposition of tax on the inside buildup of life insurance contracts, Laurie Lewis, speaking for the American Council of Life Insurers, said the regs conflict with fundamental tax principles applicable to life insurance products and principles of constructive receipt.

"Section 101 of the code is clear: gross income does not include amounts received under a life insurance contract, if such amounts are paid by reason of the death of the insured," Lewis said. However, the regulations indicate -- contrary to clear statutory authority -- that only a portion of that amount is excludable under section 101, she observed.

Lewis also attacked what she said appeared to be the regs' contemplation to tax inside buildup of life insurance contracts. In a compensatory context, if a contract is owned by the employer, the regs require the employee to include in gross income the value of any right in, or benefit of, a life insurance contract, including, but not limited to, an interest in the cash surrender value of the contract, provided to the employee during the tax year, she said.

Although the regs "reserve" on the method of valuation of the employee's rights and benefits, "it appears that they contemplate current taxation of potential future inside buildup of the life insurance contract," she said. According to Lewis, the rules would thus conflict with section 72 governing the taxation of life insurance policy benefits before the death of the insured. Although section 72 doesn't subject life insurance benefits to income tax unless there is an actual distribution from the contract, the regs would impose income tax before any actual distribution, she explained.

The regs "are contrary to the express provisions of sections 72 and 83 to the extent that they suggest that an employee participating in an equity split-dollar arrangement may be subject to current income taxation on the increase in the cash surrender of a life insurance contract," Lewis said.

Benefit or Loan

Kathleen Schluter, Northwestern Mutual Life Insurance Co., expressed concern about the policy underlying the application of two mutually exclusive regimes for split-dollar arrangements. Rather than imposing two mutually exclusive regimes, Schluter said, the regs should apply an approach that allows the parties to determine which set of rules -- either the economic benefit regime or the loan regime -- will apply.

When asked by Treasury's Michael Doran, attorney-adviser, Office of Benefits Tax Counsel, just how the parties would choose which set of rules they would apply, Schluter said the substance of the arrangements should dictate the set of rules that will apply.

Susan Schechter, Massachusetts Mutual Life Insurance Company, was also disappointed by the "rigid" and "unwarranted" application of the two regimes. She said it was interesting that the regs apply the regimes in a form-over-substance manner when in many cases the substance of the arrangements are the same regardless of their forms.

In response, Doran said Treasury was concerned about being "whipsawed" by taxpayers who don't report term permutations during the life of the arrangement but after the arrangement hold that they are receiving a death benefit. The taxpayer in that case is taking inconsistent positions, he said.

Schechter countered that such reporting inconsistencies would be an audit issue for the IRS to address and are not reasons for applying a form-over-substance approach.



Code Section: Section 7872 -- Below-Market-Rate Loans
Geographic Identifier: United States
Subject Area: Benefits and pensions
Insurance company taxation
Tax policy issues
Industry Group: Insurance
Cross Reference: For REG-164754-01, see Doc 2002-16108 (24 original pages) [PDF] or 2002 TNT
135-10 .
Author: Harris, J. Christine
Institutional Author: Tax Analysts